Question

3. Compare and contrast accounting and economic exposure. (5 marks) IBM peeds to caise $1 billion and is to en uld Assuming ar BM? (10 marks) equal, which is the Tease

Answer 1

Operating or Economic Exposure

Economic exposure is a type of foreign exchange exposure caused by the effect of unexpected currency fluctuations. The degree of economic exposure is directly proportional to currency volatility. Economic exposure increases as foreign exchange volatility increases and decreases as it falls. It can be mitigated either through operational strategies or currency risk mitigation strategies. Economic exposure, also known as operating exposure, can have a substantial impact on a company’s market value since it has far-reaching effects and is long-term in nature.

Economic exposure is obviously greater for multinational companies that have numerous subsidiaries overseas and a huge number of transactions involving foreign currencies

Translation or Accounting Exposure:

Translation exposure (also known as translation risk) is the risk that a company's equities, assets, liabilities, or income will change in value as a result of exchange rate changes. Translation risk occurs when a firm denominates a portion of its equities, assets, liabilities, or income in a foreign currency. It is also known as "accounting exposure.” Translation risk can lead to what appears to be a financial gain or loss that is not a result of a change in assets, but in the current value of the assets based on exchange rate fluctuations. Therefore, companies seek to hedge this risk as best as possible.

Translation exposure is most evident in multinational organizations since a portion of their operations and assets will be based in a foreign currency.

A variety of mechanisms are in place that allow a company to use hedging to lower the risk created by translation exposure. Companies can attempt to minimize translation risk by purchasing currency swaps or hedging through futures contracts.

Conclusion

Translation or Accounting Exposure equals the difference between exposed assets and liabilities. The trick is to decide what is exposed and what is not. Sometimes called balance sheet risk. Operating or Economic Exposure is the changes in the economic value of an enterprise as a result of an exchange rate change. This exposure is usually correlated to accounting exposure, but sometimes there is an inverse relationship.